Equity Valuation Using Multiples: An Empirical Investigation

Theoretical foundations 31come. Besides that, no empirical evidence on the performance neither for the AEGmodel nor its simplification as proposed in Ohlson & Juettner-Nauroth (2005) existso far.Taking the practical limitations of the presented fundamental equity valuationmodels into account, it is difficult to argue that practitioners ought to rely on eitherthe DDM, DCF, RIV, or AEG method when it comes to real world applications. Infact, we now understand why so many practitioners revert to the market-based multiplesvaluation approach.3.2 Derivation of intrinsic multiplesIn general, the valuation literature discusses two broad approaches to estimatingthe value of firms. The first is fundamental equity valuation, in which the valueof a firm is estimated directly from its expected future payoffs without appeal to thecurrent market value of other firms. Fundamental equity valuation models are basedon dividends, (free) cash flows, or (abnormal) earnings, and involve the computationof the present value of expected future payoffs – explained before for theDDM, DCF, RIV, and AEG method. 11 The second is market-based valuation, inwhich value estimates are obtained by examining market values of comparablefirms. This approach involves applying a synthetic market multiple (e.g., the P/Emultiple) from the comparable firms to the corresponding value driver (e.g., earnings)of the firm being valued to secure a value estimate (Bhojaj & Lee 2002, p.413-414). 12In market-based valuation, sometimes also referred to as relative valuation, atarget’s firm value equals the product of a synthetic peer group multiple and the tar-11 This book does not discuss liquidation valuation, in which a firm is valued at the “break-up”value of its asset. Commonly used in valuing firms in financial distress, this fundamental equityvaluation method is not appropriate for most going concerns (Bhojraj & Lee 2002, p. 413).12 A third approach, not covered in this book, is contingent claim valuation based on option pricingtheory. Interested readers may refer to standard corporate finance textbooks such as Brealy &Myers (2000) chapter 21, Damodaran (2001) chapter 11, Copeland, Weston & Shastri (2004) chapter9, Koller, Goedhart & Wessels (2005) chapter 20, or Spremann (2005) chapter 8 to get a basicunderstanding.